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Thursday, December 17, 2009

Scott Sumner on the efficacy of monetary policy even when the policy interest rate hit zero:

Zero rates don’t really make monetary policy more difficult, they make interest rate-oriented monetary policy more difficult... Permanent QE is just as effective as ever. Exchange rate depreciation is just as effective as ever, inflation targeting is just as effective as ever, NGDP targeting is just as effective as ever, commodity price targeting is just as effective as ever.

The strangest thing is that Ben Bernanke agrees with Sumner on this point. Just today we learn of his written reply to a Brad DeLong question on why the Fed has not adopted an explicit 3% inflation target (something that would have done wonders to prevent the great nominal spending crash of late 2008, early 2009):

...The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored. [Emphasis added]

So Bernanke agrees with Sumner in principle but is afraid of inflation expectations becoming unmoored. A look at the average 10-year inflation forecast from the Survey of Professional Forecasters says Bernanke should not be worried about inflation expectations. They have been anchored relatively well since 1997 around 2.5 percent:

Too bad Paul Krugman was not beating his influential drum with a message of inflation targeting--or in my dream world nominal income targeting--over the past year or so. Maybe others would have joined in and forced Bernanke and the Fed to think more about this option. Krugman admittedrecently it would have been the first-best economic solution to the current crisis, but avoided doing so because he thought it would be a second-best political solution. (He thought expansionary fiscal policy would be more politically feasible.) Even if Krugman and other observers have been pushing the unconventional monetary policy message more forcefully over the past year, it is still not clear the Fed would have responded. David Wessel in his new book reports that Bernanke came into the Fed wanting to target inflation. He faced, however, strong opposition and (unlike his predecessor) wanted to be a consensus builder at the Fed. He did not want to force his hand on the FOMC.

Tuesday, December 15, 2009

Adam Posen does not think monetary policy should respond to asset price bubbles by adjusting its policy interest rate. He likens this approach to a using a hammer to fix a leaky shower:

[I]f I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit.

Antonio Fatas weighs in and says not so fast; finding that right tool for the job can be elusive so in the meantime we should not shy from using the tools we have--imperfect as they are--in addressing asset price bubbles (hat tip Mark Thoma). All of this attention on asset prices is a distraction says William White in a recent paper. Asset bubbles are but a symptom of a deeper problem, an unleashed credit cycle:

To favor leaning against the credit cycle is not at all the same thing as advocating “targeting” asset prices. Rather, they wish to take action to restrain the whole nexus of imbalances arising from excessively easy credit conditions. The focus should be on the underlying cause rather than one symptom of accumulating problems. Thus, confronted with a combination of rapid increases in monetary and credit aggregates, increases in a wide range of asset prices, and deviations in spending patterns from traditional norms, the suggestion is that policy would tend to be tighter than otherwise.

From this broader perspective, there is no need to choose which asset price to target. It is a combination of developments that should evoke concern. Nor is there a need to calculate with accuracy the fundamental value of individual assets. Rather, it suffices to be able to say that some developments seem significantly out of line with what the fundamentals might seem to suggest. Finally, there is no need to “prick” the bubble and to do harm to the economy in the process. Rather, the intention is simply to tighten policy in a way to restrain the credit cycle on the upside, with a view to mitigating the magnitude of the subsequent downturn...

White address a number of concerns regarding this leaning against the credit cycle approach. This one in particular caught my attention:

As for the more general concerns about undershooting the inflation target, this could lead to outright deflation, but it need not. In any event, it needs to be stressed that the experience of deflation is not always and everywhere a dangerous development (Borio and Filardo, 2004) The experience of the United States in the 1930’s was certainly horrible, but almost as surely unique (Atkeson and Kehoe, 2004). There have been many other historical episodes of deflation, often associated with bursts of productivity increases, in which falling prices were in fact associated with continuing real growth and increases in living standards. As noted above, there can be little doubt that serious problems can arise from the interaction of falling prices and wages and high levels of nominal debt. But the essential point of leaning against the upswing of the credit cycle is to mitigate the buildup of such debt in order to moderate the severity of the subsequent downturn...[emphasis added]

As readers of this blog know, I made this very point in comparing the deflation threat of 2003 with the deflation threat of 2009. Had the Fed been less fearful of the benign deflationary pressures in 2003 they would not have held the federal funds rate so low for so long and, as a result, there would have been less buildup of debt and thus the potential for the harmful form of debt deflation we face today. (In case there are any doubts as to whether the deflationary pressures of 2003 were truly benign see here and here.)

Read the rest of Williams White's article Should Monetary Policy "Lean or Clean"here.

Monday, December 14, 2009

It is easy to get caught up in the issues of the day and lose sight of important long-term structural developments. That is why I appreciate Niall Ferguson's work as it provides a broad, long-term perspective on recent events. Via Joe Wisenthal, here is Ferguson's latest interview where, among other things, he discusses the long-run outlook for the United States in terms of security, finance, and influence:

James MacGee has an interesting article that compares the post-housing boom period in Canada with that of the United States (hat tip James Hamilton). Specifically, he notes that the housing bust that took place in the United States did not occur in Canada and attempts to explain this difference by looking at the two most common reasons given for the housing boom: (1) loose monetary policy and (2) relaxed lending standards. Looking at both factors, MacGee makes the following observations:

The similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. to generate the boom and bust. This is not to suggest that “loose” monetary policy did not put upward pressure on housing prices—indeed, both Canada and the U.S. experienced substantial levels of house price appreciation. However, the Canada-U.S comparison suggests that some other factor drove both the more rapid house appreciation and set the groundwork for a U.S. housing bust.

MacGee's claim that monetary policy in the two countries were similar is based on the fact that both policy interest rates followed similar paths during the housing boom (see his central bank target rate figure). Since these indicators of monetary policy did not differ much, he concludes it must be the case that the distinguishing factor between the two countries were the lax lending standards in the United States. I certainly agree that the monetary policy was not the only factor in the housing boom. I hesitate, however, to conclude that because the policy interest rates followed similar paths the stances of monetary policy were also similar. As Nick Rowe pointsout its not the level of the policy interest rate but where it is relative to the natural interest rate that determines the stance of monetary policy. Consequently, to make a convincing case that monetary policy was similar in Canada and the United States during this time one needs to show the difference between the natural interest rate and the policy interest rate--called the policy rate gap hereafter--for both countries followed similar paths.

So what does the policy rate gap show? It is not easy to answer this question because it requires an estimate of the natural rate of interest for both countries. I am only aware of natural interest rate estimates for the United States covering the housing boom period. Therefore, let me approximate the idea of a natural rate of interest--and will latter corroborate this approach--by looking at the growth rate of labor productivity in both countries relative to the policy interest rate. The natural interest rate, after all, is a function of individuals' time preferences, productivity, and the population growth rate. Of these three components, the one that seems to have changed the most during the housing boom in the United States was productivity. Below is a figure showing the quarterly year-on-year growth rate of labor productivity minus the ex-post real policy interest rate for both countries. (The policy rate in Canada is the overnight rate and in the United States it is the federal funds rate. The ex-post real federal funds rate is used to make a consistent comparison since I could not find quarterly inflation forecasts for Canada.) A positive gap indicates accommodative monetary policy while a negative gaps indicates tightness. (Click on the figure to enlarge it.)

This figure reveals a large policy rate gap for the United States while for Canada it shows one hovering around zero. The figure indicates, then, that monetary policy was not the same in both countries. The Canadian monetary authorities got it about right while the Fed was too accommodating. Now in case you are not convinced that this measure is truly approximating the difference between the natural interest rate and the ex-ante real policy interest rate I have constructed the actual policy rate gap measure for the United States as a comparison. The natural interest rate data comes from this paper by Fed economists John C. Williams and Thomas Laubach while the ex-ante real federal funds rate is constructed by subtracting from the federal funds rate the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters. The figure below graphs the two U.S. policy rate gap measures:

The similarity of these two series indicates the productivity-based approximation of the policy rate gap does a decent job. The low interest rates in the United States, then, appear to have been more distortionary than those in Canada.

So what is the take away from this analysis? For starters, monetary policy was an important part of the U.S. housing boom-bust cycle. Moreover, it is possible that the relaxed lending standards themselves cannot be entirely separated from this loose monetary policy. Over at Econbrowser commentator David Pearson sums it up nicely:

Weak underwriting standards and the "Greenspan Put" were joined at the hips. What you call weak underwriting was actually just collateral-based lending (hence no-doc loans basically eliminated ability to pay as a criterion, and zero-down loans depended entirely on the creation of equity value through appreciation). Where did the confidence come from to adopt widespread collateral-based lending? I believe a great deal of it came from the Fed's asymmetric monetary policy. Remember, the underwriting standards were ultimately set by the volume of demand (from hedge funds and the like) for higher-yielding securitizations, and, in turn, that demand was generated by ultra-low interest rates at the short end...

I would also note that during the housing boom interest rates charged to non-conventional mortgages were closely tied to the federal funds rate as seen in the figure below (see this post for more on this point.)

Source: FHFA

Of course, none of this is new. John Taylor already showed us via his Taylor Rule that those countries that deviated the most from the Taylor Rule's tended to have the greatest housing booms.

Tuesday, December 8, 2009

Many observers have made the case that monetary policy was too loose in the early-to-mid 2000s and, as a result, helped fuel the credit and housing boom. Some observers, however, see little role for loose monetary policy in explaining the distortions that arose in the financial system. For example, Arnold Kling's impressive paper on policies that contributed to the financial crisis finds little importance for monetary policy with regard to the bad bets and excessive leverage taken on by financial institutions during this time. While there are a number of factors that contributed to these developments in the financial system, I want to push back on the notion that monetary policy's role was relatively unimportant. There are at least two reasons why monetary policy was important here: (1) it helped create macroeconomic complacency and (2) it created distortions in the financial system via the risk-taking channel. Let's consider each one in turn.

I. Macroeconomic ComplacencyThe first point is related to the reduction of macroeconomic volatility beginning in the early 1980s that has become known as the Great Moderation. This development can be seen in the figure below which shows the rolling 10-year average real GDP growth rate along with one-standard deviation bands. These standard deviation bands provide a sense of how much variation or volatility there has been around the 10-year average real GDP growth rate. The figure shows a marked decline in the real GDP volatility beginning around 1983.

Now there are many stories for this reduction in macroeconomic volatility and one of the more popular views is that the Federal Reserve (Fed) did a better job running countercyclical monetary policy. In fact, Fed Chairman Ben Bernanke made this very point in a famous 2004 speech. I think there is merit to this view, but not quite in the same way as does Bernanke. During this time one of the key ways through which the Fed was able to reduce macroeconomic volatility was by responding asymmetrically to swings in asset prices. Asset prices were allowed to soar to dizzying heights but cushioned on the way down with an easing of monetary policy (e.g. 1987 stock market crash, 1998 emerging market crisis, 2001 stock market crash). The Fed also used its powerful moral suasion ability to goad creditors into helping the distressed and systemically important LTCM hedge fund. All of these actions served to prevent problems in the financial system from affecting the real economy and thus, were probably a big factor behind the "Great Moderation" in macroeconomic activity. However, they also appear to have caused observers to underestimate aggregate risk and become complacent. This, in turn, likely contributed to the increased appetite for the debt during this time. This interpretation of events was recently alluded to by Fed Vice-Chairman Donald Kohn in a 2007 speech:

In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the “Great Moderation” back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions.While we cannot be sure about the ultimate sources of the moderation, many observers believe better monetary policy here and abroad was one factor; if so, central banks may have accidentally contributed to the current crisis.

So a macroeconomic complacency created in part by the Federal Reserve set the stage for one of the biggest credit and housing booms in modern history.

II. The Risk-Taking Channel of Monetary PolicyThe risk-taking channel of monetary policy is one that looks at the relationship between the Fed's interest rate policy and risk-taking by banks. Leonardo Gambacorta of the BIS summarizes how this link works:

Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.

He goes on to empirically show a strong link between the easy monetary policy and risk-taking by banks during the early-to-mid 2000s using a database of 600 banks in the Europe and the United States. Similar work has been done by Tobias Adrian and Hyun Song Shin as I noted in this previous post. In their paper they find the following:

We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.

I see the macroeconomic complacency idea discussed above as setting the stage for and reinforcing the risk-taking channel of monetary policy. Of course, if so then this undermines the the Sumnerian view that all was well with a 5% trend growth rate for nominal expenditures during the Great Moderation but that is another story.

Monday, December 7, 2009

Previously on this blog I have looked at the extent of hyperinflation in Zimbabwe and as well as recent progress (i.e. the defacto dollarization of the economy) the country has made in overcoming this problem. I bring this up because today one of my former students gave me the following Zimbabwe bill dated 2008 (click on pictures to enlarge):

Yes, this a 100 trillion dollar note with fourteen zeros. Note that the bill apparently has several anti-counterfeiting measures like the golden bird statue on the right front. That is surprising; surely the opportunity cost of counterfeiting this bill far exceeded any benefit. Just how worthless is this currency now? Below is a picture that answers this question succinctly (click on picture to enlarge):

Friday, December 4, 2009

There has been some interesting conversations on the stance of monetary policy in the past few days between Arnold Kling, Scott Sumner, and Josh Hendrickson. Part of the challenge in measuring the stance of monetary policy is that there are multiple transmission channels through which monetary policy can work: the interest rate channel, the balance sheet channel, the bank lending channel, the wealth effect channel, unanticipated price level channel, the exchange rate channel, and the monetarist channel. (See here and here for a discussion of these channels.) Knowing the true stance of monetary policy depends in part on knowing which monetary transmission channels are most important at a given time.

Tobias Adrian and Hyun Song Shin make the case that one of more important channels in recent years is one that really hasn't been considered yet: the risk-taking channel. This channel measures the stance of monetary policy by looking at balance sheet quantities of financial intermediates:

We reconsider the role of financial intermediaries in monetary economics. We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets. Our findings suggest that the traditional focus on the money stock for the conduct of monetary policy may have more modern counterparts, and we suggest the importance of tracking balance sheet quantities for the conduct of monetary policy.

While this channel works through balance sheet quantities of financial intermediates, it is important to note that changes in the federal funds rate are important in influencing the size of the balance sheets. This, then, provides another reason why the Fed's low interest rate policy in the early-to-mid 2000s was highly distortionary. The WSJ recently ran a story that highlighted Adrian and Shinn's work. Here are some key excerpts:

Fed officials are now debating the differences between bubbles as a way to understand them better and come up with the right solutions. Two economists influencing the debate are Tobias Adrian, a New York Fed researcher, and Hyun Shin, a Princeton professor. Their work shows that the credit bust was preceded by an explosion of short-term borrowing by U.S. securities dealers such as Lehman Brothers and Bear Stearns.

For instance, borrowing in the so-called repo market, where Wall Street firms put up securities as collateral for short-term loans, more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. As the value of the securities rose, so did the value of the collateral and the firms' own net worth. That spurred firms to borrow even more in a self-feeding loop. When the value of the securities started to fall, the loop went into reverse and the economy tanked.

The lesson: The most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices. That means keeping these debt levels down might be one way to prevent busts.

Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. "Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage," says Mr. Adrian. That, in turn, "has real effects on the economy."[emphasis added]

His co-author, Mr. Shin, says "clumsy financial regulations" aren't enough to stop boom-bust cycles. "This would be like trying to erect a barrier against the incoming tide using wooden planks with big holes," he says. Using interest rates is the "most effective instrument" for regulating risk-taking by firms, he says in a new paper.

No one at the Fed has yet come out in favor of raising interest rates to stop the next bubble, but the idea is being discussed more seriously among Fed officials. Mr. Bernanke has been following Mr. Adrian's work closely.

I find this very encouraging. Apparently, Ben Bernanke is taking this risk-taking channel seriously along with its implications: the low federal funds rates in the early-to-mid 2000s was a mistake. Maybe we won't repeat the same mistakes after all.

I don’t doubt that many of his [Gagnon's] former bosses at the Fed, Mr Bernanke included, agree with his premises; they may even find the specific estimates reasonable. But the barriers to further quantitative easing at the Fed aren’t economic, they’re political. The Fed was taken aback by how critics on Wall Street, in foreign central banks, and in Congress screamed that its modest, $300 billion Treasury purchases were monetising the government deficit and paving the path for future inflation. They have added to the atmosphere of hostility now surrounding the Fed. The Fed has essentially decided to pursue a second-best (i.e. insufficiently aggressive) monetary policy because a first best monetary policy could bring political perdition.

So bad politics trumps good economics. Bill Woolsey notes this proposal would help push nominal spending back toward its long-run trend.

Alan Greenspan was a legend in his time and there was no shortage of praise for him back then. For example, who can forget Bob Woodow's 2000 book Maestro: Greenspan's Fed and the American Boom. While I was aware of this Greenspan devotion, I never realized the extent to which it rose until I read David Wessel's In Fed We Trust. In the chapter title "The Age of Delusion", Wessel directs us to a paper delivered at a major economic symposium in 2005 that had this passage in the introduction:

No one has yet credited Alan Greenspan with the fall of the Soviet Union or the rise of the Boston Red Sox, although this may come in time as the legend grows. But within the domain of monetary policy, Greenspan has been central to just about everything that has transpired in the practical world since 1987 and to some of the major developments in the academic world as well. This paper seeks to summarize and, more important, to evaluate the significance of Greenspan's impressive reign as Fed Chairman... There is no doubt that Greenspan has been an amazingly successful chairman of the Federal Reserve System. (pp. 11-12)

This 86-page paper praising Greenspan's record epitomizes the cult of personality Greenspan had at this time and it is one reason why we got the economic debacle we are in now. Under Greenspan leadership, the Fed asymmetrically responded to swings in asset prices as they were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. While this approach probably contributed to the "Great Moderation" in macroeconomic activity it also appears to have caused observers to underestimate aggregate risk and become complacent. It is likely that it also contributed to the increased appetite for the debt during this time. These developments all helped spawn the current crisis. Greenspan's cult of personality meant little-to-no questioning of his policies.

Now not everyone bowed to emperor Greenspan. There were a few who saw his record differently. Here is one such prominent economist writing also in the year 2005 in the magazine Foreign Policy:

U.S. Federal Reserve Board Chairman Alan Greenspan is credited with simultaneously achieving record-low inflation, spawning the largest economic boom in U.S. history, and saving the world from financial collapse. But, when Greenspan steps down next year, he will leave behind a record foreign deficit and a generation of Americans with little savings and mountains of debt. Has the world's most revered central banker unwittingly set up the global economy for disaster?

Unfortunately, this view was the exception not the rule. Let us never allow another cult of personality to develop within the Federal Reserve.

Wednesday, December 2, 2009

The Economist's Free Exchange blog is shocked to hear this from Federal Reserve Bank of Philadelphia President Charles Plosser:

"Since expectations play an important role in the dynamics of inflation, it is important that policy act in a manner that keeps expectations well-anchored near the Fed’s inflation objective,” Plosser said in a speech in Rochester. “If expectations do become unanchored, then the Fed will have lost its credibility and either inflation or deflation could arise…So, anticipation and forward-looking policy are essential if the Fed is to achieve its goal of low and stable inflation."

I agree with the Free Exchange blog that inflation becoming unanchored is not an issue now. In fact, Plosser's own bank does the Survey of Professional Forecasters which shows the Fed still has an amazing amount of inflation-fighting credibility. Below is a figure based on this data (click on figure to enlarge):

Note that the 10-year forecast has been and continues to be around 2.5%. Based on Plosser's comments above, one would think it might have been inching up lately, but no it more or less has flat-lined since the late 1990s. I wonder what Plosser thinks of this data; how does he reconcile it with his comments above?

What do we know about expected inflation? According to Arnold Kling not much if we look to financial markets:

I'm also not convinced that we can read expected inflation in the TIPS market. Take right now, for instance. The TIPS market is saying that inflation is going to be low. But is that what the people who are buying gold believe? I don't think so...I dare you to try to tease inflation expectations out of financial markets right now.

Kling's bigger point here is that Scott Sumner's claim that real interest rates shot up late last year--and hence, monetary policy tightened--cannot be verified since we cannot properly tease out a correct measure of expected inflation from financial markets. In the case of TIPs this is because there was an increased liquidity premium at the time and, as a result, the difference between the treasury nominal yield and the TIPs real yield may have been reflecting more than just expected inflation. I always like an empirical dare so let me respond to Kling's challenge this way: instead of turning to financial markets let's look to the Philadelphia Fed's Survey of Professional Forecasters. This survey of economic forecasters looks at inflation forecasts and should provide a robustness check against the TIPs implied expected inflation. The big drawback to this approach is it only has quarterly data. With that said, below is the average 1-year ahead inflation forecast for the GDP deflator plotted along with the 5-year inflation forecast from TIPs (click on figure to enlarge):

Both series show a sudden change in expected inflation beginning in 2008:Q3. The survey measure of expected inflation, however, drops far less than the TIPs measure. Still, there is (so far) a permanent drop in expected inflation that is hovering around 1.5%. This implies a rise in real rates. How much is not clear. While this leaves some ambiguity as to what happened to real interest rates, I am still convinced that monetary policy was effectively tight late last year based on other measures.

Tuesday, December 1, 2009

Given the recentdiscussion on stabilizing nominal spending as a policy goal I found this article by Evan F. Koenig of the Dallas Fed to be interesting:

The article shows that the optimal monetary policy rule in such an economy has the Federal Reserve target a geometric weighted average of output and the price level. In a realistic special case, the monetary authority should target nominal spending. [emphasis added]

This is an accessible article that makes use of standard AD-AS model with sticky wages. It also reaches conclusions about the relationship between nominal spending and deflation similar to the ones I discuss in this paper.

It seems Martin Feldstein cannot avoid speculating about the demise of the Euro. Since the late 1990s he has been making thecase that there are just too many institutional and economic differences in the EU nations for a single currency to work. In short, Feldstein believes the Euro area falls way short of being an optimal currency area. The past decade of relative success for the ECB has done nothing to change his view. In fact, earlier this year he discounted this period as a "lucky time" for ECB policymakers:

Mr. Feldstein pointed out that the past decade has been, until recently, a lucky time in Europe. European country economies weren’t buffeted by severe economic problems, or big unemployment problems, allowing the European Central Bank to focus on price stability. But now, economic conditions are deteriorating rapidly, and some countries are being much harder hit than others...“In my judgment, the next few years will be an important testing time for the EMU and Europe,” Mr. Feldstein said - one in which the possibility of one or more countries choosing to withdraw from the EMU cannot be ruled out.

That was written in January 2009 when Europe seem poised to implode. Now that ECB has weathered that storm Feldstein still questions the Euro's survivability:

The economic recovery that the euro zone anticipates in 2010 could bring with it new tensions. Indeed, in the extreme, some countries could find themselves considering whether to leave the single currency altogether.

Although the euro simplifies trade, it creates significant problems for monetary policy. Even before it was born, some economists (such as myself) asked whether a single currency would be desirable for such a heterogeneous group of countries. A single currency means a single monetary policy and a single interest rate, even if economic conditions – particularly cyclical conditions – differ substantially among the member countries of the European Economic and Monetary Union (EMU).

[...]

The European Central Bank is now pursuing a very easy monetary policy. But, as the overall economy of the euro zone improves, the ECB will start to reduce liquidity and raise the short-term interest rate, which will be more appropriate for some countries than for others. Those countries whose economies remain relatively weak oppose tighter monetary policy.

Feldstein acknowledges there would be technical and political hurdles to overcome for a country to abandon the Euro. Barry Eichengreenargues these hurdles are probably large enough to prevent a country from leaving the currency union. Obviously, Feldstein is less confident on this point than Eichengreen. Interestingly, Desmond Lachman, who foresaw many of the emerging market crisis of the 1990s, sees a "ticking time bomb" for Spain, Greece, Portugal, and Ireland from the "straightjacket of the Euro-zone membership." He too does not see the hurldes to a breakup of the Eurozone as unsurpassable. As I noted in a previous post, Argentina in the 2001-2002 period provides a good example of a country for which the technical and political hurdles--including a financial crisis, the largest-ever sovereign default, and political chaos--were not enough to prevent it from leaving the dollar zone. Never say never.